Corporate Finance

Rollin’ on Down

How Integrated Electrical Services and Comfort Systems USA succeed where other "roll-ups" flounder.
S.L. MintzSeptember 1, 1999

The fast-growth corporate model called the roll-up has hardly been on a roll this past year. “The r -word became unfashionable last fall,” says Jeff Evans, a securities analyst at Credit Lyonnais Securities. On the list of 1998 initial public offerings, “some roll-ups started missing targets right out of the box,” explains Patrick Hurley, a partner with Howard, Lawson & Co., a Philadelphia investment banking firm. “So investors said, ‘Enough; let’s talk about something else.’”

The resulting fall in share prices devalued the principal “currency” these companies use– their own stock–as they “roll up” acquisitions of one competing local concern after another in whatever highly fragmented national market they have chosen to consolidate.

Suddenly, new sellers were less inclined to accept stock for their businesses, and the roll-ups, too, were reluctant to give out too many shares at depressed prices. “In good times, the mix is 75 percent stock and 25 percent cash,” says chairman Steve Harter of Houston-based Notre Capital Ventures II, who orchestrated the IPO of roll-up Comfort Systems USA Inc. in June 1997, among others. “It’s almost inverted when the stock is undervalued.”

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So the news that Integrated Electrical Services Inc. (IES) is sustaining its acquisition pace, with strong profitability, gives fresh confidence to the cadre of consolidators that have similarly forged their reputations on external growth. The product of more than 60 acquisitions of commercial, industrial, and residential electrical contractors–most completed since it went public in January 1998–IES represented a particularly aggressive example of the roll- up. The Houston company hit $1.1 billion in annual sales in June, compared with $387 million the prior year. Pro-forma sales in the year ended September 1997 were around $312 million.

“When we went public,” recalls IES chief executive officer and former CFO Jim P. Wise, “we said we would do 5 to 10 percent internal [earnings] growth.” Meanwhile, investors were advised to expect external earnings growth of another 15 percent, for a robust annual total of 25 percent. Earnings have beaten those targets, and Wise believes the 25 percent growth goal will remain realistic at IES through at least four more years of active acquisitions. In part, that’s because the $75 billion total market of electrical contractors remains very fragmented.

Source of the Sizzle

Overall, most roll-ups planned external growth during the headier times before last year’s downturn. Mixing cash and possibly notes in with their stock, depending on market conditions, consolidators in numerous industries were successful in luring sellers with the prospect of price gains outstripping the returns available to most private companies. “The sizzle comes from taking companies with 50 cents in earnings and, through acquisitions, growing them to $1 in earnings in only a couple of years,” says securities analyst Mel Cody of Sanders Morris Mundy, in Houston. A Sanders Morris index of 20 roll-up companies began outpacing the S&P 500 in mid-1995.

But IES got caught with other roll-ups in the midyear plunge in share prices–and felt the consequences in the acquisition market. IES stock had approached $24 late in July 1997, more than 50 percent above the IPO price the prior September. By mid-October, it had fallen to approximately $13.

While some roll-ups were spoiling things by failing to meet IPO expectations, Internet stocks made things worse by stealing the market limelight. Suddenly, the flimsiest of dot-com securities drew the attention of growth-oriented investors away from the more- prosaic consolidated enterprises. That proved difficult for the new roll-ups, which are constantly in search of critical mass as they piece together the bits and pieces in their industry of choice. For them, it’s grow or vanish, if their stock trades too cheaply.

A new investor perception began to emerge. The roll-ups “became value stock instead of growth stock,” says Gordon Beittenmiller, CFO of Comfort Systems, a Houston-based company built in less than three years into a $1.3 billion collection of local and regional providers of heating, ventilation, and air-conditioning equipment and services.

The most visible evidence of this value-stock assessment: the tempering of price-earnings multiples for roll-ups. After a peak multiple of 17 a year ago, the multiple, for IES, for example, fell to about 13 this past July.

What investors miss in this story “are millions of dollars of free cash flow,” says Steve Harter. “Once you get a company up and running with critical mass, you can take the free cash flow and keep the program going.” Companies acquired are “big enough so that banks and other financial institutions will pay attention.” At that stage, $1 in free cash flow can fetch $3 in bank loans, says Harter– plenty of capital to nurture external growth when equity becomes too expensive.

Paying for External Growth

IES and Comfort Systems have done relatively well among roll-ups in keeping up the pace of their acquisitions. Both try to avoid management disruption by leaving operations largely in the hands of the sellers. The consolidating parents mainly assume such corporate functions as cash management and raising capital.

“On paper, you think that combining some operations can cut overhead and juice earnings,” says Comfort Systems’s Beittenmiller, but “in the majority of situations where we have done that, companies have underperformed.” So instead, the top- management ranks at Comfort Systems and IES are made up of several dozen independent managers–all of whom closely watch the stock price.

By July, the stock price of IES had recovered to 181/4. For the six months ended March 30, IES’s earnings jumped 90 percent, to $19 million, on a 120 percent rise in revenue to $413 million.

IES chief executive Wise can see the day when there’s relatively less rolling-up going on at his company. “At some point, [we’ll manage the] transition to internal growth,” and investors will be left with a company growing its earnings annually at closer to 10 percent. But by then, he says, investors will own shares in a dominant, national, multi-billion- dollar company, with cost reductions and knowledge synergies reflected in its profit increases.

Some observers are skeptical about roll-ups’ long-term prospects in general. “Think about a normal business growing through acquisition: one electrical contractor buying a contractor in a neighboring town,” says Prof. Samuel Hayes III of Harvard Business School. “What is involved in integrating one or two companies? It takes enormous preoccupation of management.”

And investors are wary of external growth. “Success depends on a number of things, not least the viability of the stock price as a payment method,” Hayes says. “The market looks differently at internally generated growth,” he explains, “because it is systemic and can be expected to compound forward as an annuity.”

Still, says IES’s Wise, two more quarters this year like the second quarter could convince investors once again that his company is an exception to the rule. Especially if the acquisition pace keeps up. Through May, IES had acquired 22 companies with revenues of $210 million. Wise believes that once the company establishes a firm track record of internal growth, IES will then get more credit from investors for external growth.

That will suit James Canova just fine. Canova, who built Canova Electric Inc., in East McKeesport, Pennsylvania, before selling to IES in April of this year, keeps an eagle eye on his new company’s stock price. “All IES presidents have the same mode of thinking,” he says. “We want the stock price to go up.”